Special Report: How a vicious circle of self-interest sank a California city

Tue Nov 13, 2012 7:58am EST

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By Tim Reid and Cezary Podkul and Ryan McNeill

SAN BERNARDINO, California (Reuters) - When this sun-drenched exurb east of Los Angeles filed for bankruptcy protection in August, the city attorney suggested fraudulent accounting was the root of the problem.

The mayor blamed a dysfunctional city council and greedy police and fire unions. The unions blamed the mayor. Even now, there is little agreement on how the city got into this crisis or how it can extricate itself.

"It's total political chaos," said John Husing, a former San Bernardino resident and regional economist. "There is no solution. They'll never fix anything."

Yet on close examination, the city's decades-long journey from prosperous, middle-class community to bankrupt, crime-ridden, foreclosure-blighted basket case is straightforward — and alarmingly similar to the path traveled by many municipalities around America's largest state. San Bernardino succumbed to a vicious circle of self-interests among city workers, local politicians and state pension overseers.

Little by little, over many years, the salaries and retirement benefits of San Bernardino's city workers — and especially its police and firemen — grew richer and richer, even as the city lost its major employers and gradually got poorer and poorer.

Unions poured money into city council elections, and the city council poured money into union pay and pensions. The California Public Employees' Retirement System (Calpers), which manages pension plans for San Bernardino and many other cities, encouraged ever-sweeter benefits. Investment bankers sold clever bond deals to pay for them. Meanwhile, state law made it impossible to raise local property taxes and difficult to boost any other kind.

No single deal or decision involving benefits and wages over the years killed the city. But cumulatively, they built a pension-fueled financial time-bomb that finally exploded.

In bankrupt San Bernardino, a third of the city's 210,000 people live below the poverty line, making it the poorest city of its size in California. But a police lieutenant can retire in his 50s and take home $230,000 in one-time payouts on his last day, before settling in with a guaranteed $128,000-a-year pension. Forty-six retired city employees receive over $100,000 a year in pensions.

Almost 75 percent of the city's general fund is now spent solely on the police and fire departments, according to a Reuters analysis of city bankruptcy documents - most of that on wages and pension costs.

IN THE DARK

San Bernardino's biggest creditor, by far, is Calpers, the public-employee pension fund. The city says it owes Calpers $143 million; using a different calculation, Calpers says the city would have to pay $320 million if it left the plan immediately.

Second on the city's list of creditors are holders of $46 million worth of pension bonds - money borrowed in 2005 to pay off Calpers. The total pension-related debts are more than double the $92 million owed to the city's next 18 largest creditors combined.

Complicating matters were obscure budgeting procedures that left residents in the dark. The word "pension" doesn't appear once in the most recent 642-page budget, and retiree costs are buried in detailed departmental line items.

"I've been asking for years for the pension costs," said Tobin Brinker, a former council member and pension-reform advocate, who lost his seat last year to a challenger backed by nearly $100,000 in contributions from the fire and police unions. "I still don't know the number."

James Penman, the longtime city attorney who critics say is closely aligned with the unions, alleged during a council meeting this summer that 13 of the past 16 city budgets had been falsified. He has refused to elaborate on that accusation since, but told Reuters that he hasn't retracted it, either.

The Securities and Exchange Commission has opened an informal inquiry into the San Bernardino situation because of the city's bond obligations. The federal Department of Housing and Urban Development, which has provided funds to the city in the past, says it is conducting a routine periodic audit of the city's books that began before the bankruptcy.

No regulatory or law-enforcement agency has announced any criminal probe. Recently hired city finance officers do say they have found evidence of terrible accounting and record-keeping.

But unlike in the small Southern California cities of Bell, where eight city officials face trial on allegations that they stole from the public, and Vernon, where three officials have been convicted of corruption, San Bernardino's problems appear to be mainly the result of back-scratching on an epic scale.

It's a pattern common throughout the Golden State - and while the particulars are quite different, it is akin to what happened in other states with severe financial crises, such as Illinois and Pennsylvania.

"2.5 AT 55"

By the time San Bernardino's council met behind closed doors on September 17, 2007, it was already clear the city was in trouble.

Just six months earlier, a report by consulting firm Management Partners showed that spending was outpacing revenue, pension costs were escalating and the city was quickly accumulating unfunded retirement liabilities.

Last decade's housing boom had papered over the deep economic problems stemming from the shutdowns of a huge steel mill in the 1980s and the Norton Air Force Base in the 1990s. Now the boom was over. Tax revenues were poised for a big fall: Between 2007 and 2011, they dropped 30 percent, according to Husing, the regional economist.

Yet on this day in 2007, the city was about to raise pension benefits again, in a deal allowing non-public-safety workers to retire at age 55 with a pension equal to three-quarters of their salary. Called "2.5 at 55," it calculated annual pensions at 2.5 percentage points of final salary for each year worked - 75 percent for 30 years.

It wasn't nearly as good a deal as the one police and firefighters enjoyed - a "3 percent at 50" plan passed a year earlier. That enabled the public-safety workers to retire at 50 with a pension of up to 90% of their final salary. Regardless, "2.5 at 55" was what union negotiators had asked for, and the council was poised to rubber-stamp it.

But then something happened. And in a city which has a particularly toxic brand of politics, what transpired depends on who you talk to.

According to four people present at the meeting, Penman, the city attorney, brought a pregnant co-worker to the session. By their account, Penman's co-worker made an emotional case for an even more generous pension deal. Otherwise, she said, she would be forced to leave San Bernardino and seek work in a city with better benefits. She had her family to consider, she said.

Penman vehemently denies that any of this took place. "Welcome to San Bernardino politics," he said.

RUNAWAY TRAIN

That afternoon, in public session, the council unanimously voted to award its non-safety workers 2.7% at 55 - more even than the union sought. That tiny fraction could raise the pension on a $100,000 salary by $6,000 per year. Penman, in office since 1987, earned $164,799 last year, according to city payroll data.

"In hindsight I am not proud of this vote," said Brinker, who was on the city council at the time. "The recession hit barely a year later. This was one more log on the pension bonfire."

Meanwhile, San Bernardino continued to boost wages along with benefits. The average salary for a full-time San Bernardino firefighter in 1997 was $75,610, adjusted for inflation into 2010 dollars. By 2010, it was nearly $147,000, according to a Reuters analysis of Census Bureau data.

City wages were a runaway train, according to the Management Partners report. The city charter automatically calculated police and firefighter pay using a formula linked to wages offered by comparably sized cities - most of which were much wealthier than San Bernardino. Efforts to amend the charter were strongly opposed by the safety unions and voted down by the council earlier this year.

City workers took advantage of compensation rules, common among public employees in California, that made retirement deals even better. Key to this was boosting an employee's eve-of-retirement wages, which form the basis of the pension calculations.

Mike Conrad, chief of the fire department from 2006 to 2012, said he saw managers negotiate a promotion in their final year, to boost their final salary. It was not uncommon for someone to move into a position with a $30,000 annual pay rise shortly before retirement, he said.

Retiring employees are also able to extract big one-time "cash outs." In San Bernardino, eight hours per month of unused sick time can be rolled over and saved year after year, without limit. Come retirement, 50 percent of the total can be taken in cash. The same goes for unused vacation time: up to 460 accrued hours of vacation - nearly three months of salary - can be cashed in at the fire department, Conrad said.

The police have a similar deal. In 2009, patrol lieutenant Richard Taack retired at the age of 59, after 37 years of service. He took home $389,727 that year, including $194,820 in unused sick time and $33,721 for unused vacation time, according to city payroll records. Shortly after Taack retired - on an annual lifetime pension of $128,000 - he was hired part-time by Penman's city attorney's office, at $32 an hour.

POTHOLES AND EMPTY LOTS

Taack's 2009 income was nearly double that of the city's entire street-sweeping department. In 2011, overtime pay alone for the police department - $2,766,175 - exceeded the total payroll of 12 other San Bernardino city departments, according to the Reuters analysis of payroll data. Taack didn't respond to requests for comment.

"I can't begrudge the man for receiving what he's entitled to under the contract," said David Green, the head road sweeper, who has seen his department cut to five people from 13 when he joined in 1995. But he said there should be a better balance between the safety forces and other departments. "Nobody wants to drive a car and have to hit a three-foot pothole."

Indeed, potholes scar downtown San Bernardino. Many stores are shuttered. Abandoned lots sit unkempt. Since the bankruptcy filing, city finance officials have put forward proposals to close libraries, senior centers and a cemetery.

Andrea Travis-Miller, interim city manager, told the council this summer that 250 non-safety positions had been eliminated in the past three years to save money - and implied that police and fire benefits were crowding out other essential services. "I believe that city buildings, roads, trees and parks that have begun to show neglect would deteriorate further if more cuts are made," Travis-Miller said.

The police and fire unions fiercely dispute the charge that large salaries and pensions are to blame for the predicament. They point to the housing crash, which left the city with the fourth-worst foreclosure rate in the country.

Scott Moss, head of the firefighters union, said 20 positions had already been cut from the fire department, leaving about 120 people.

"There's been mismanagement for years," Moss said, over coffee in a local restaurant. He noted that Mayor Patrick Morris had majority support on the city council for six years until union-backed members regained a majority in March. "The mayor and his people are trying to make us look bad."

Moss, 46, a fire paramedic, said he might retire at 53. Payroll records show a base pay of $94,500, and total 2011 wages, with overtime, of about $147,000. Moss confirmed the base figure but didn't comment on the overtime number.

SICK OF THE BLAME

Moss said he is sick of people blaming pensions. "You go to bankruptcy, you got to blame somebody. So they say it's the benefits, it's the overtime - it's everybody but them," Moss said. "But what have they been doing these last six years?"

On sick-pay cash-outs, Moss said: "If you call in sick, you're a bad employee. So my guys don't call in sick. Then you get all this time you are owed - and you get vilified."

He added: "This is a dangerous city. It's an old, decayed city. It burns. There are gangs. The pay and benefits attract the police and firefighters it needs. Without them, you lose all the good ones. That's the balance."

Crime and gangs are real dangers in San Bernardino. In 2010, according to Federal Bureau of Investigation data, the rate of known violent crimes - 8.15 per 1,000 people - was higher than in any other city in the region.

A five-minute drive from city hall, on a residential street, sit flowers and homemade signs next to a picture of Angel Cortez. The 22-year-old was shot in the back of the head in May in what police suspect was a "gang-related" murder. His body was found in the backyard of a vacant home. His killers had first tried stuffing his body into a trash can, then returned to dig a hole, before unsuccessfully attempting to burn his body, police said.

Mayor Morris, a 74-year-old former judge who's been in office six years, is scathing about the power he says the unions have over much of the city council. The unions, he said, "wag the dog." (Council members are paid just $50 a month for their service, but also receive a car allowance worth $600 a month).

He rejects Moss's argument that he should take responsibility for the financial crisis. He is particularly critical of his two-time challenger for the mayorship, city attorney Penman, who he said "has blocked all efforts to reform the budget" on behalf of the unions.

Morris added: "I have no vote on the council. I can only veto a vote if it is 4 to 3. All I have is the power of persuasion. I've told them a bunch of times to be far more conservative, not to be so generous with our unions, and it's advice they have largely ignored."

'MEAN, DIVISIVE, CORROSIVE'

Morris isn't running for re-election when his term expires a year from now. "The politics of this place are and have been for decades mean-spirited, divisive, and it's corrosive to the extreme," he said.

Penman denies being influenced by the unions. He said he takes campaign contributions from the police and firefighters like most other elected officials in California. He said he actually split with the police union in 2007 - a rupture reported at the time - and wasn't endorsed by them again until his last re-election bid in 2011. Campaign finance records show that he received $30,000 in contributions from the police and fire unions in 2011.

Of his critics, Penman said: "You are hearing from some people whose ethics and honesty are very much in doubt."

A key facilitator of San Bernardino's generous retirement packages was Calpers, which manages pensions both for state workers and for many city and county employees across California.

Led by a board of directors who are all themselves members of the pension plan, Calpers has for decades pushed to sweeten benefits for retirees.

A 1999 law championed by Calpers, known as SB 400, cut the retirement age five years and increased benefits for state workers, all on the premise that a rising stock market meant benefits could be juiced up at little or no cost. Many cities and counties, though not required to go along, were happy to heed Calpers' analysis. About half - including San Bernardino — adopted the richer benefit formula.

When the stock market tumbled in 2000, cities and towns suddenly had to ramp up payments to Calpers to make up for the hit to their fund balances, which were heavily invested in shares. Fee-hungry investment bankers stepped into the breach.

Led by the now-defunct Lehman Brothers, they persuaded many cities - including San Bernardino and Stockton, which is also in bankruptcy - that the best way to satisfy growing obligations to Calpers was to borrow the money via so-called pension obligation bonds. San Bernardino raised $50 million in 2005 by issuing these notes. Between 1999 and 2009, 26 California cities sold about $1.7 billion of debt to fund their pensions, including bond issues that were used to pay off earlier debt.

'CALPERS VERSUS WALL STREET'

Yet even in bankruptcy, reducing pension costs by cutting benefits is not an option - at least according to Calpers.

The pension agency says the benefits are carved in stone, arguing that from the day a worker is hired, the pension plan in place on that day for that person can never be reduced in value under any circumstances, including municipal bankruptcy.

That argument has never been tested in court: When the Bay Area city of Vallejo went bankrupt in 2008, it declined to challenge the pension payments to Calpers, in part because of the daunting legal costs involved.

But the pension-bond insurers who are now on the hook for defaulted bonds in both Stockton and San Bernardino have signaled their intention to do battle with Calpers in bankruptcy court. San Bernardino, in an unprecedented move, has already stopped making payments to Calpers.

"Calpers is the 800-pound gorilla in the room," said Michael Sweet, a bankruptcy attorney at Fox Rothschild, which is not representing any parties in the San Bernardino bankruptcy. "No one has yet taken on Calpers. This is going to be a huge fight, and it's going to be Calpers versus Wall Street."

Calpers says it wasn't responsible for the decisions made in San Bernardino. Alan Milligan, chief actuary at Calpers, said the 1999 legislation "provided options to cities and agencies to change their retirement benefits, but it did not encourage or force them" to do so. "Calpers does not give advice about how an agency should pay for their retirement benefits."

Brad Pacheco, a spokesman for Calpers, said San Bernardino lost major employers in recent years and was one of the U.S. cities hardest hit by the foreclosure crisis. He said San Bernardino's annual pension costs account for just 10 percent of the total city budget.

Those figures, however, exclude the city's $46 million in pension-bond debt plus its unfunded debt to Calpers. The city in its bankruptcy filing says it is $143 million in the hole to Calpers. Calpers says that if San Bernardino pulled out of the plan, it would owe $320 million to cover its current and future obligations.

MISERABLE COMPANY

San Bernardino and Stockton are hardly alone. A handful of other small California cities, including Atwater, Hercules and Compton, are teetering near bankruptcy.

Big California cities that run their own pension plans also have deep problems. San Jose, hub of Silicon Valley, and San Diego, biotech center of California, both passed pension reforms in June in the face of unmanageable retirement benefits. They are now defending those measures in court against public-employee lawsuits.

In Los Angeles, Mayor Antonio Villaraigosa, a former labor organizer, led a push to raise the retirement age and cut pensions for new, non-safety city staff. He exempted police and fire employees. A ballot measure sponsored by former Mayor Richard Riordan aims to include them in the cuts, too.

And while California has the biggest pension debt in the United States in dollar terms, it's not the worst off. Illinois and Kentucky plans are battling for the dubious distinction of having the lowest ratio of assets to liabilities, according to the Center for Retirement Research at Boston College.

The chronic mismanagement in San Bernardino, though, is a common feature of local government in California and around the United States. Much power over municipal finance lies in the hands of those with the most at stake — city employees, elected officials and others who depend directly on government for their livelihood. And California is moving to put even more responsibility and funds, not less, in their hands.

One of Governor Jerry Brown's marquee initiatives is "realignment," an effort to move more public-safety, welfare and prison services from state control to the cities and counties. Local governments are more flexible and more responsive to local issues, Brown argues, and thus able to make better decisions.

Charles McNeely, who served three years as San Bernardino's city manager after 13 years in the same post in Reno, Nevada, quit last March, citing the "toxic" atmosphere on the council. He had warned repeatedly that without change, the city faced ruin. In a presentation to the city council in August 2010, he said spending was far outpacing revenue and predicted a budget deficit of $40 million for this fiscal year.

"I don't know how you could come out of that meeting not understanding we had a serious problem," McNeely said in an interview. "I told them, 'You're headed for trouble, it's a train wreck. You can't keep doing business this way.'"

(Additional reporting by Peter Henderson and Jim Christie in San Francisco. Editing by Jonathan Weber and Michael Williams.)